How Options Imbalances Affect Price Dynamics

As discussed several times, markets can be loosely divided into two regimes: trending, and mean-reverting. The majority of trading literature has been devoted to exploiting these market characteristics. Less attention, however, is paid to the explanation of their existence. They are often attributed to investors’ over-, underreaction and/or market inefficiencies.

Reference [1] looked at these market properties from a different perspective. It examined how the options gamma imbalances contribute to the market intraday momentum or reversal.

Recall that an option gamma is,

Gamma measures the rate of change in the delta with respect to changes in the underlying price. Gamma is the second derivative of the value function with respect to the underlying price.

Most long options have positive gamma and most short options have negative gamma. Long options have a positive relationship with gamma because as price increases, Gamma increases as well, causing Delta to approach 1 from 0 (long call option) and 0 from −1 (long put option). The inverse is true for short options

When a trader seeks to establish an effective delta-hedge for a portfolio, the trader may also seek to neutralize the portfolio's gamma, as this will ensure that the hedge will be effective over a wider range of underlying price movements. Read more

The article pointed out,

Establishing delta-neutrality may cause either return momentum or reversal depending on the sign and size of the imbalance vis-a-vis market prevailing liquidity. We find that a large and negative (positive) aggregated gamma imbalance, relative to the average dollar volume, gives rise to an economically and statistically significant end-of-day momentum (reversal).

It further showed that rebalancing of leveraged Exchange Traded Funds at the end of day also has the same effect on the price dynamics,

We compare this channel to the rebalancing of leveraged ETFs and find that the effect generated by leveraged ETFs is economically larger. Consistent with the notion of temporary price pressure, the documented effects quickly revert at the next day's open.

In short, both delta hedging and rebalancing of leveraged ETFs contribute to the stock market intraday momentum or reversal. The authors even managed to develop trading strategies based on these imbalances and they earned superior risk-adjusted returns.

We found the authors’ explanation of the intraday price dynamics plausible; however, we think that their strategies are rather difficult to implement.

What do you think?

References

[1] A. Barbon, H. Beckmeyer, A. Buraschi, and M. Moerke, The Role of Leveraged ETFs and Option Market Imbalances on End-of-Day Price Dynamics, 2021. https://ssrn.com/abstract=3925725

Originally Published Here: How Options Imbalances Affect Price Dynamics